What is Decentralized Exchanges: A Comprehensive Guide!

2017 has taught the crypto sphere great lessons on security. The raised number of hacks throughout the year with the millions of dollars had stolen which intimates a clear message that “cryptocurrency trading needs a makeover”.

The cornerstone for this makeover is- “Decentralized exchanges”!

In this article, we’ll discuss an outline why DEXs (Decentralized Exchanges) are the future of cryptocurrency ecosystem and what is the advantages decentralized exchanges architecture offering in comparison to the traditional centralized network.

There are massive blockchain startups charging into the direction of decentralization.

So, pick the winner wisely and make a huge amount of fortune… let’s start with the basic on today’s topic!

Decentralized Technologies and Cryptocurrencies are booming! The numbers speak for savior: market capitalizations have analyzed the roof, trading volume has skyrocketed, and endorsement from individuals to institutions and governments has hit a global scale.

As currently, most cryptocurrency exchanges are centralized. They keep their systems off-chain, which means that they work as escrows for their users, and transactions are not recorded on the blockchain.

This leads to huge security breaches and risky storage of data, funds, and private keys.

Trading brings risks, however, traders should not feel insecure about any risks rather than those they are already willing to take.

2017- A Period Plagued by Hackings

2017 was the year that places crypto on the map. The same year that drove it into the reach of malicious hackers.

There are many attacks that took place throughout the course of the year; from exchanges to ICO funds to wallet services, attackers feasted on system vulnerabilities.

Considering the current market prices, the total amount of the stolen funds is approximately $500mln. This figure doesn’t even serve 2017 hackings including Bitstamp and Bitfinex , and the infamous Mt. Gox breach that pushed the market into hibernation.

Moving back to July, attackers compromised Parity- a well-known Ethereum multi sig wallet, operating off with 153,000 ETH (worth approximately $200mln at its present exchange rate).

Youbit- formerly called “Yapizon”, in April of 2017 lost 3,816 BTC which was worth of $5mln during the hack; the total loss of this attack currently is approx. $50mln.

So now, you may realize what a big loss our economy has experienced. After these hacks and loss, to prevent or reduce such factors Decentralization was bought into existence.

What is a Decentralized Exchange?

A decentralized exchange is a market that does not depend on a third party service to hoard the customer’s funds. Instead, trades happen directly between users (P2P) via an automated process.

This system can be accomplished by generating assets (that depict shares in a company) or proxy tokens (crypto assets that portray some fiat or cryptocurrency) or via a decentralized multi-signature escrow network, amongst different solutions that are currently under development.

Throwbacks and incompetence of centralized exchanges depart the model with quite a few advantages.

Majority of semi-decentralized exchanges are coming into action as the hybrid models between centralized & decentralized marketplaces to deliver the best of both worlds.

Digital Currency Market Overview with the Flaws of Centralized Exchanges

2017 Cryptocurrency market in digits:

+3400%* = Market capitalization of cryptos is facing an exponential growth: from less than $18B to more than $600B in 2017.

>170 = Total of cryptocurrency exchanges (live with traffic), raising at an exponential pace and uncountable figure of exchange projects.

In Addition, more than 99% of crypto transactions are processing via these exchanges.

Let’s move on with factors in comparison with both types of exchanges- Centralized and Decentralized

Centralized vs. Decentralized Exchanges

1) Control of Funds

Users of centralized platforms make deposits to the exchange to facilitate the trading transaction. These funds are maintained by the centralized service. This means that order-books and custody lies firmly in the hands of the centralized network service

In a decentralized platform, users interact directly with their peers without any need for a central server. There’s no centralized service that is in possession of order books as well as custody. Funds are controlled by the participants and users in the platform.

2) Anonymity

Some centralized platforms permit anonymous trading accounts on their platforms. However, the raft of government rules raised in recent months has led to the adherence to firm KYC and AML laws. Therefore it is difficult to trade anonymously on a centralized platform.

Decentralized platforms are all about anonymity. Consider them as the distributed blockchain-equivalent of centralized networks.

3) Authentication

Users of centralized exchanges rely on the platform to authorize and authenticate their transactions. The platform acts as a third-party intermediary offering trusted crypto services.

In Decentralized exchanges, the user may not rely on a third-party intermediary. Via a number of blockchain protocol implementations and smart contracts, the entire network is to offer trust-less authentication of crypto service transactions.

Merits of Decentralized Exchange

Cheaper and Faster Transactions

Potential to offer a platform that facilitates faster and cheaper with cost-effective crypto trading transactions. The elimination of the third-party authenticator extremely cuts off the fees and lag time prior to buy/sell orders are opens up.

More Difficult to Hack

This is less susceptible to malicious hacks than the centralized counterparts. A number of hacks have occurred on major centralized platforms. As decentralized exchange has no single entry point, similar to the blockchain. A hacker needs to compromise the majority of the network to commandeer the system.

Seamless Integration with Safe Hardware Wallets

It provides seamless integration with famous hardware wallets like “Trezor” and “Ledger Nano S” which enables secure transaction space. Users can trade directly via their hardware wallets to the smart contract of multiple decentralized exchanges. This isn’t possible in centralized platforms as users have to manually input private keys to move trade via hardware wallet to centralized exchanges which may be risky full of keylogging attacks and malicious phishing.

Funds Managed by Users Instead of a Central Corporation

The decentralized platform is owned and managed by all the participants so there’s no central authority that owns custody of customer deposits. The command of the money always lies in the hands of the users as the network operates P2P network architecture. Transactions happen between peers using smart contracts which can be processing via private keys of the participants. Users control their private keys and funds at all times in a decentralized exchange.

Demerits of Decentralized Exchanges

Difficult to Use

There is a reason why centralized exchange like “Coinbase” and “Binance” are well-known, they are easy to use. The plethora of smart contracts that are required to be navigated can be dizzying even for a tech-savvy individual. Centralized exchanges consist easy to understand forms and buttons whereas many decentralized exchanges have a jumbled dashboard that hard to get used to.

Lack of Robust Facets and Functionalities

Most decentralized platforms only embrace the basic cryptocurrency exchange function. Much advanced trading tools and facets are conspicuously lacking which isn’t the case with central counterparts. The lack of stop loss, margin trading, and a host of other trading attributes is one of the reasons for not achieving much fame in the wider crypto commerce environment.

With centralized exchanges, you believe that:

They will not compromise your money through lost credentials, hardware failure, or other negligence.

They will keep it safe from hacking, theft, etc. from internal or external sources.

Also, they will not rob it from you and will act honorably.

Moreover, they will not take out of business where your coins could end up stuck.

This is much belief to trust into a body that is fully unregulated and may not exist in the same country as you.

If something goes unusually as it did in the past (Mt. Gox, Cryptsy, Mintpal etc.); you could end up losing all your wealth with no government protection (like you connect with banks).

Cryptocurrency platforms are not regulated and your funds are not insured. Additionally, you are handing your wealth to a complete stranger/group of strangers and hoping that they will give it back your money.

Maybe you are starting to realize why this might be an issue? This is where DEXs come into the role.

Decentralized Exchanges

These exchanges platforms permit you to trade in a secure manner as they are away from central individual or authority.

It may not be as pretty as “Poloniex” however money is in your control while using “Bitshares”

There are a number of methods including the use of smart contracts where this point comes as a benefit

The basic idea is that the platform or a central “site” never owns your money. You keep the money and hoard it in your account until you trade.

When a trade is accomplished it is between the buyer and seller. In some manner, it is like a trustless escrow service.

This way you need to trust a central party to trade. If a DEX collapses in some way there is no way to lose your money.

What May Slow Down the Choice of Decentralized Exchanges?

By permitting customers to remain, custodian of their funds, seem emphasized and obvious by all above discussed hacks stories. So, why everyone is not using them?

Some aspects are driving down their adoption like “Education” and “Technology”.

“Centralized exchanges are potentially unable to handle large volumes of users, touting decentralized trading platforms as a better alternative. However, decentralized exchanges are not as user-friendly as centralized options, and may not have the funds to support mass trading due to small numbers of users.”

What is a Truly Decentralized Exchange?

What does it mean to be a truly decentralized exchange? Are there any criteria? here are the set of questions:

Does it need an email, Facebook or Google sign up?

Are the money ever sent to a third party address rather than your own?

Does the exchange utilize a replacement, intermediate token / IOU /coin or a colored coin approach?

Does a profit percentage go back to an entity, individual or company?

Is there a central entity, individual or company operating the exchange?

Are there any withdrawal limits?

Are the order matching and order books centralized?

Can only specific pairs of coins be trading?

Are there any cost listing on the platform?

Well, if the answer to any of the above questions is “Yes”, then it is not a truly decentralized exchange.

RadarRelay – 0x order book to find and trade any ERC20 token (Live on the MainNet)

Open protocols for Decentralized Exchanges:

Open Protocols are establishing and operating decentralized applications (dApps) on a common basis: some are designed specifically for decentralized exchanges (i.e. Ox) where others seem suited (i.e. Omise).

Moreover, they create synergies by permitting “anyone” to build their own amenities on top of them: it fosters renovation and is effective for native dApps to interact with each other.

For decentralized exchanges, open protocols bring the benefits of creating frequent pools of liquidity by permitting any project launched on top to communicate with each other.

0x – Open protocol for the decentralized platform on the Ethereum blockchain

Swap Protocol (by AirSwap Team) – Peer-to-peer protocol for trading Ethereum tokens, without order books (to be open in near future)

Footnotes

However, it is quite clear that DEXs will pave a safer way to trade cryptocurrencies. The multiple failures that people have incurred via a centralized exchange are one of the most compelling reasons for their use.

DEXs could be the “key” to secure trading.

However, most DEXs are still in a fairly embryonic state which means that they are not easy or simple for people to use.

It is inevitable that we have more centralized exchange failures on that people lose their money.

This convinces the customers to consider DEXs as an option. Sometimes it takes strict lessons to learn how to do things right.